I can assure everyone in the German government that without a very generous restructuring, and some sort of growth prospect, by 2013 there won't be much of a Greek society, let alone economy, left to follow any sort of programme. At this rate of collapse, by July 2013, Papandreou will have long escaped the country carried away by a helicopter from some government building's rooftop (à la manière de IMF traditionnelle) and army generals/gangsters with armed goons will be running parts of the country like Somalian warlords.

Well, I would assume that political chaos is not conducive to any form of repayment and is bad for the Eurozone generally speaking. Also political turmoil has a bad habit of spreading (as the Arab world recently has reminded us)...
Other than that, however, you're probably right

Well, default is not conducive to repayment either. And if the German banks (or at least the ones that have the ear of the BuBa) are geared as hard as I think they are, a full default won't be that much worse for them than a thirty percent haircut (which is, after all, what the bonds are trading at). You can only go bankrupt once - there are no "doubleplus insolvencies."

Further, if the Greek bonds are not repaid because the Greek are rioting in the streets, then obviously it is those brown-skinned barbarians who don't understand civilised virtues of thrift and austerity that caused the virtuous, prudent and generous German banks to go bust. Whereas if the German banks go bust because they take the same, negotiated, haircut as everybody else, then it'll be a lot harder to prevent people from arguing that the bailout should come with strings attached.

And avoiding strings on the private banking sector is the point of the exercise. Sure, they may tear Europe apart in the process. But since when does the BuBa or the EPP care about the European interest?

The 40-50% haircut in Greek bonds is already priced into the secondary market prices.

The issue here must be institutions which hold Greek bonds in "investment" books which are marked to "hold to maturity" values. Institutions which have Greek debt in "trading" books which are marked-to-market have already realised the losses.

So the key to the whole thing is probably the existence of large "hold to maturity" positions in German banking books, with maturity dates before 2013.

Banking regulators worthy of the name would require that banks set aside reserves to cover likely losses on "investment" books, of which the deterioration of the mark-to-market would be a basic indicator.

And competent regulators would have forced progressively larger haircuts on the private banking sector as collective exposure to foreign markets grew. But that would have required the BuBa to pay attention and police creditors instead of waxing lyrical on the moral responsibilities of debtors to fulfil mathematically impossible obligations.

The more I think about it, the more a central bank guarantee of a lower bound on the exchange rate strikes me as turning idiosyncratic risk into systemic risk. Or, if you will, socialising the cost of buying currency swaps to hedge against sudden currency movements by replacing it with restrictions on fiscal and interest rate policy.